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The Coming Nuclear Winter Base Metals To: the Geneva Conference on Base Metals Investing From: Frank Veneroso

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The Coming Nuclear Winter Base Metals To: the Geneva Conference on Base Metals Investing From: Frank Veneroso The Coming Nuclear Winter Base Metals To: The Geneva Conference On Base Metals Investing From: Frank Veneroso October 3, 2006 Introduction I am going to give you a bearish presentation on base metals. I have titled this presentation the “Coming Nuclear Winter For Base Metals”. It is my belief that the current base metals prices, which are a multiple of marginal cost, which is their long run price equilibrium, are simply ludicrous. They are here only because of unprecedented speculation. This speculation has resulted in price increases in base metals in real or inflation adjusted terms that are far greater than in any half decade cycle since the late 19th century. Base metals are not assets. They are goods of use. Like all such goods they must follow the basic principles of microeconomics. That means that such record high prices will in time, ration demand or, to use the more colorful language of the market place, they will destroy demand. At the same time they will encourage supply. The end result will be huge surpluses and an inevitable reversion to mean and more. That implies prices below marginal cost yet once again. I believe this process has been well underway for some time. The yet higher prices this year along with their perseverance will make matters worse – worse perhaps than they have been in any cycle since the late 19th century. Because generalized inflation in this cycle has been especially low, once the industry specific pressures on costs abate and reverse – as they always do - we will see that marginal cost has not changed, even in nominal terms. But the excess of record overshooting in this cycle will lead to extremely deep undershooting of marginal cost when this cycle finally reverses and runs its course. This is the microeconomic side of the story. Less compelling but still real is the macroeconomic side. In almost all base metal cycles, after those several years of a bull market which triggers the microeconomic forces of reversal described above, there occurs as well a global economic slowdown or recession. This adds to the inevitable downswing in the base metals cycle by lowering global demand below trend. It is now widely recognized that the four year U.S. economic expansion is now endangered by a bursting of the U.S. housing bubble. It is less commonly acknowledged that the investment boom in China – the other global economic locomotive – will end in a bust as well. My assessment is that some measure of both will materialize in the coming year or two. This will add to the forces that will round trip this extraordinary base metals bubble. It is not a necessary condition of the bear market I foresee, but it will probably be a contributing cause. Nuclear Winter In Base Metals Page 1 11/5/2006 The laws of economics that have made base metals terribly cyclical since the onset of the industrial revolution and before have not been repealed. Except this time the excesses are unprecedented. There will be a commensurate downswing in amplitude and duration. Brace yourselves for a nuclear winter for base metals markets. Has The Commodity Bear Market Begun? I believe it has for myriad reasons. About two months ago the principal commodity indices were at key moving averages and trendlines that provided support for the bull move in commodities over the last five years. These technical patterns looked toppy. A break of the five year trend was suggested. Below is an executive summary from a piece I wrote at that time suggesting that the commodity bubble may be bursting. Executive Summary 1) The increase in real commodity prices in this cycle is the largest that has ever occurred over a half decade cycle. Since the onset of the industrial revolution. 2) There has been nothing about the overall macro environment since the beginning of this decade that justifies such an increase in real commodity prices. 3) There was underinvestment in some commodity sectors at the end of the prior decade due to excessive enthusiasm about technology versus basic industries. But investment in commodity producing industries has now caught up and there are rapid increases in supply in many commodities. 4) What explains the unusually strong behavior of such prices in this decade? Investment and speculative flows. There has been a bubble in commodity prices created by an unprecedented surge in investment and speculative funds seeking to crowd into a market which is too small to accommodate today’s huge financial flows. 5) The CRB has come down to its 200 day moving average time and time again in this bull market. Overall the 200 day has contained the 5 year trend in commodity prices. Typically it has broken it marginally and then rallied to a new high. But this last time it rallied off this key moving average, it failed to make a new high. That was a first for this cycle. 6) Key will be whether it recovers above the 200 day and rallies, or whether it falls to a new low for the move. Today it is probing a new low. A little more weakness and various long term trend lines that have defined ascending support for this bull market will be broken. 7) We have now had a commodity bull market for years. Decades of history tell us that when prices rally this far and for this long we are well into the phase of overinvestment which creates the gluts of the next down cycle. Nuclear Winter In Base Metals Page 2 11/5/2006 8) In most commodities supply growth is now considerable. The lagged response of output to investment promises yet more rapid supply growth to come. 9) Micro economics tells us that high prices should be rationing demand as well. That is less apparent so far. But there are signs. 10) In many cases the combination of both demand rationing and supply encouragement have thrown markets into significant surplus. These micro forces are probably the key reason why the CRB may be “rolling over”. 11) In some cases like grains and natural gas such surpluses have forced prices to fall despite still rising investment and speculative demands. In others like base metals mega speculative and investment flows are so strong that prices remain at record levels despite markets shifting into surplus. 12) The pressures of hedge fund and institutional buying of commodity futures has pushed nearby futures upward versus the spot price. The first large contango appeared in energy. More recently this cost of carry problem has expanded to other commodities. 13) Now commodity baskets overall are in supercontangos. The trend no longer seems to be a reversion to the past norm of backwardation. The pressure of fund buying of futures plus growing surpluses is making the overall basket contango ever wider. The cost of carry for some baskets now exceeds 15% per annum. 14) No one can afford the huge cost of carry that now prevails and will continue to prevail. As more and more institutional investors recognize this all important change is permanent, the fund flows behind the commodity bubble will abate and eventually reverse. The beginning of this process may be contributing to a possible “rolling over” of the CRB. 15) Has global economic growth decelerated? Probably a bit. Is that enough to change the course of commodity prices? At the margin yes, but only if the other two more relevant factors discussed above are in force. 16) The impact of a global growth slowdown is next year’s story. The U.S. economy is being slowed by a bursting of a dangerous housing bubble. But it still has late cycle momentum. A serious U.S. slowdown is probably a 2007 event. Again, a Chinese hard landing probably lies ahead, but that again is a 2007 story. 17) Of course, if commodities have been bubblized by hedge funds, pensions, and endowments, then commodity prices can be taken down by perceptions of a global economic slowdown before one actually materializes. Nuclear Winter In Base Metals Page 3 11/5/2006 18) If the micro forces of supply and demand and the prohibitive cost of carry of commodity derivatives act to fell commodity prices now, speculators may conjure up a slowing global economy to amplify any new downtrend that might be underway, even if the real world macro depressants still lie ahead. Since I wrote this in August we have had a very sharp and protracted decline in the commodity indices. Nick Moore of ABN AMRO provides us with the following chart. -Winds of Change, Nick Moore, ABN AMRO, September 28, 2006 I believe this move is for real and that it has commenced largely for the reasons I outlined in August Investment Or Speculation? I presume you are all commodity “mavens”. You look to the CFTC commitment of traders data to see if metals markets have too many “spec longs”. If you do, you are misled. This cycle has been different. First the hedge funds have moved to disguise their positions as commercial rather than speculative positions through their arrangements with brokers. But, more importantly, they now operate mostly “over the counter”. These positions do not show up in the CFTC data for the most part, and, to the extent they do, they show up as dealer (commercial) positions. How can we assess this? I like to present the following chart to illustrate. Nuclear Winter In Base Metals Page 4 11/5/2006 Now these are commodity derivatives positions of U.S. commercial banks as reported to the U.S. office of the Controller of the Currency.
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